Don’t Overlook The Financial Sector

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Some might think he’s kidding, but Fred Cummings says investors shouldn’t summarily dismiss banking stocks. Though it currently seems like one of the worst sectors and a most inopportune time, Cummings believes there are golden opportunities to be found — particularly among select small and midsize banks.

It’s an area that he knows quite well. Cummings is the president of Cleveland-based Elizabeth Park Capital Management, which focuses on opportunities in the financial services sector.

It’s understandable if you’re scratching your head. After all, the S&P Financials Sector index fell 18.4% in 2007 and was down 13.9% during the first quarter. What’s more a fair number of prognosticators say the near-term horizon is less than cheery.

Yet to launch his firm’s hedge fund last year, Cummings took $2.8 million to start to build what he projects will be a portfolio of 15 to 30 stocks.

What’s your outlook for the rest of 2008?
The first half of 2008 will be difficult for bank earnings — but I think a lot of that is already reflected in the price of the stocks in the group. Banks will start to turn around in 12 to 18 months, and stock prices should climb as credit quality concerns dissipate. Credit quality should stabilize in the second half of 2008, and improve in 2009. I also think merger activity will accelerate in late ’08 and clearly in ’09.

What do you make of the calamities of some of the bigger banks?
Companies like those are spread out among so many activities. No one — not even their own managers — could properly analyze them or the risk profile of their businesses. Meanwhile, I stick to small- and mid-cap banks because it is simply easier to get my arms around their core strengths and weaknesses.

What’s the profile of a bank that’s poised to bounce back?
Banks with strong credit underwriting skills will get back on track the soonest: Their level of nonperforming assets will be lower than the industry average. Once nonperforming assets are north of 1% of a bank’s total, I have reason to get concerned. I also look for limited loan exposure to the construction and real estate development industries. That’s a tough area to grow in right now and banks such as United Community Bancshares in Georgia and Chicago-based Corus Bancshares, with large residential development lending portfolios, are likely to have credit issues. The companies I track have, on average, 15% of their loan portfolios tied into real estate development; I tend to get worried if a financial institution has 30% or more of its loan portfolio tied up there.

Finally, I look over a bank’s deposit base and examine its mix of core deposits such as CDs, and savings and checking accounts — which is something that investors can check in a company’s quarterly or annual reports. The average bank holds 80% of its funding base in these types of core deposits currently.

What’s a stock you like with low credit risk?
City National Bank, a wholly-owned subsidiary of City National Corp. (CYN) is based in Beverly Hills,